The wolf pack stalks Europe

The financial sector has to be reduced in scale and importance in Europe, and the EU needs a strong central bank and an integrated fiscal system. In fact, everything that isn’t being considered in the current euro panic

The Greek government convened an emergency meeting of expert advisers in January. A man from the IMF flatly told the prime minister George Papandreou that the only way out was to dismantle the Greek welfare state. A man from the Organisation for Economic Cooperation and Development (OECD) proposed a test: when everyone, including all your supporters, are fighting mad, he said, you’ll know you’ve done enough. The theory behind these arguments held that markets impose discipline on states. Bond buyers judge the determination of the government’s austerity programmes; then they decide whether to trust in the repayment of debt. Given sufficiently harsh and credible measures, interest rates would fall and Greece’s refinancing could proceed.

But there was a problem. Promises are cheap. Even if the theory is right, for the policy to work, the cuts have actually to be carried out. But implementation takes time. Refinancing of previously existing debt is a precommitment; it depends on confidence that the government will carry through, long before it actually does. And how can a mere policy announcement engender such belief, in a state that has a bad reputation to begin with? Whatever was said, when Greece’s current bonds matured the actual cuts would still lie ahead (1). And the more severe the announced cuts, the less credible they would be.

This argument logically destroyed the idea that any austerity programme could reopen private bond markets on terms acceptable to Greece. The only way to avoid default was for Europe to refinance the Greek debt, bypassing the markets. So the question became: how to persuade the EU to do that? This challenge propelled the economic crisis to the centre of a political game. The Greek government still had to announce severe cuts and other “reforms” – not to pacify the markets, but to meet the needs of Angela Merkel. Her voters in Germany would not tolerate a “bailout” unless they saw painful sacrifices from the Greeks. Meanwhile the Greek government declared unshakeable allegiance to its debt and to the euro – while subtly reminding France and Germany that Greek default and exit, with inevitable contagion to Portugal and Spain, could not be excluded if help did not come.

Second epiphany

As economic policy, this game made no sense for Europe. The cuts would mean joblessness, lost tax revenues and therefore little actual deficit reduction in Greece. You cannot cut 12% of GDP from total demand – as the eventual IMF programme called for – without cutting GDP itself. Falling Greek GDP would also cost jobs for German and French factory workers who make goods sold in Greece. Except relative to the unpayable interest rates on offer from private markets, Greece’s ability to service its debts would not improve.

Nor – without a devaluation, made impossible by the euro – would Greece’s competitiveness get better. The measures that might help over time, namely the programme of public administration and tax reforms to which the Greek government was already committed, would be much harder to implement in the atmosphere of crisis, cuts and exorbitant interest rates.

As the debt deadline neared, Europe’s leaders laboured under arcane rules, an unwieldy collective process, domestic political backlash and the burden of their own limited understanding. High officials insisted fanatically that cutting public spending and deficits would foster economic growth. Predictably they came to the verge of disaster. After Chancellor Merkel appeared to repudiate a funding package, panic swept the eurozone. The price of credit default swaps on Portugal and Spain, and also on their banks, soared – testament to the fragility of the European financial system with its lack of EU-wide deposit guarantees. Merkel blinked and a refunding package finally went through.

But now came a second epiphany. The Greek bond bailout only made the European financial crisis worse. To see why, imagine you own a Portuguese bond. Repayment is uncertain, so you dump it, or purchase a credit default swap. The bond price then falls, making Portugal’s refinancing harder. At the limit, the best way to assure payment is to close the private bond markets and (as with Greece) to blackmail the EU. And a rescue package is practically certain, given the general view that Portugal has not been as “irresponsible” as Greece. And after Portugal, there is Spain, to which the same rules apply.

The speculators could thus force the Europeanisation of Mediterranean debts, and in mid-May this happened with breathtaking speed. There was panic, just as in the US in September 2008 and for the same reason: it was a panic spurred by speculators pressing reluctant political leaders to action. Like all victims of blackmail, President Sarkozy expressed anger. And Merkel announced a retaliatory ban on naked shorting on government bonds. But what can they do? A bond sale or credit default swap on Greece, Portugal or Spain can be consummated entirely outside Europe – in New York or the Cayman Islands. So the moment they came under pressure, the speculators only regrouped for another attack.

Ineluctable decline

The trillion-dollar scale of the EU action calmed things for a moment. But then it became clear that the EU governments can only borrow from each other. They cannot create net new reserves and they cannot finance growth and bond bailouts at the same time. Only the European Central Bank (ECB) can do that. At first the actual role of the ECB seemed vague, but then it emerged that the bank really was buying up European bonds. With this, the debt problem came under control; but now the supply of euros became highly elastic, and the euro detached itself from its hard-money moorings and began an ineluctable decline. Statements by the ECB president insisting that it was only recycling term deposits, not creating new money, caused confusion and fostered a sense that Europe’s leadership did not know its own mind. Flight bordering on panic continued.

And so a third pillar of financial wisdom begins to come clear. In a successful financial system, there must be a state larger than any market. That state must have monetary control – as the Federal Reserve does, without question, in the US. Otherwise the markets play divide-and-conquer against the states. Europe has devoted enormous effort to creating a single market without enlarging any state, and while pretending that the Central Bank cannot provide new money to the system. In so doing, it has created markets larger than states, and states with unbearable debts, which now consume them. Only the ECB could relieve this situation, and only by abandoning its charter in the face of the pressures of the real world.

How far the ECB will finally go, and how far it will take up the quantitative easing pioneered by the Federal Reserve in late 2008, remains unknown. But even if it finally commits to this course, ending the financial crisis for now, the economic crisis will deepen. Each “rescued” country will get, in turn, just enough assistance to repay its debts. The price, each time, will be massive cuts in public budgets. The banks will be saved, but growth, jobs and the achievements of the welfare state will be destroyed. The IMF man gets his way. And the European recession grows deeper and deeper. This will be proof of the proposition that it was fiscal stabilisation – and not monetary policy – that actually brought the US economy back from the brink of a great depression.

Rich people in poor countries

This European crisis will therefore continue until Europe changes its mind. It will continue until the forces that built the welfare state in the first place rise up to defend it. It will continue until Europe faces the constitutional deficiencies of its system, which come from the absence of an integrated measure for macro-economic stimulation. Europe needs a single integrated tax structure, a central bank dedicated to economic prosperity, and a reduction of the financial sector. But most of all it needs an automatic fiscal process to offset recession and demand shortfalls in its less-wealthy regions, and the process should work not only through governments but also directly to Europe’s citizens.

From a purely technical standpoint, there are some quite easy ways to achieve this. For instance, a European Pension Union could set the goal of equalising minimum pensions across Europe, so that working people in Portugal, Greece or Spain do not retire on a material standard far below those of Germany or France. There could be a Europe-wide topping-up of minimum wages, similar to the highly effective Earned Income Tax Credit in the US. The European Investment Bank could foster the creation of transnational European universities on the US land grant model, strengthening higher education throughout the peripheral regions. Examples could be multiplied but the principle is plain: the correct response to mass unemployment and the resulting budget deficits is to expand public and private expenditure in the deficit regions. This is the only way to break the vicious circle of budget cutting, debt deflation and depression now under way.

Some would view this argument as a proposal to tax Germans for the benefit of Greeks, but from an economic perspective that view is entirely incorrect. The point and purpose is to mobilise unemployed resources throughout Europe and get them into employment. This imposes no cost on anyone presently employed, since it expands the flow of real goods and services, available to all. An integrated tax system, for its part, would help stem the pandemic of tax evasion in Greece and other southern countries in Europe. To the extent that there is a higher tax burden as reforms take hold, it should fall on rich people in poorer countries and not on poorer people in the rich ones.

The recent experience casts into question whether any economic recovery can occur as long as the financial markets are able to bet massively against euro assets as a whole, something that happens primarily on the credit default swap (CDS) markets. And this underlines the necessity of cutting down the financial sector until it no longer threatens the EU. Cutting down the financial sector can be achieved by regulation, by taxation and by restructuring the debts of the Mediterranean states. Regulations should prohibit CDS transactions by any European financial entity on European sovereigns, and force that kind of gambling into offshore havens. If banks fail as a result of hedged or unhedged bets, they should be taken over, and run as public utilities. A common European tax on realised capital gains could (in principle, anyway) be administered by national governments; a tax on financial transactions, though no panacea, is long overdue. If capital controls must be reimposed to arrest financial contagion, so be it. In a contest between the state and the financial markets, with the survival of stable and civilised government in question, the state cannot be allowed to lose out.

Fewer innocents

To restructure public debts that cannot be paid, Europe needs a sovereign insolvency process comparable to Chapter IX covering municipal bankruptcy in US law – as long proposed by Professor Kunibert Raffer of Vienna University. That would permit national governments to maintain essential services while relieving themselves of unpayable debts. There would be consequences for the banks, avoidable only by insuring deposits and standing ready to assume control when debt restructuring for a country leads to insolvency for a bank. But losses already incurred must be recorded somewhere, and there are far fewer innocents in any bank than in any country.

These are radical steps. But can anyone seriously question that radical steps are needed? Can anyone now doubt that the architecture of neoliberal Europe is falling apart? No. The choice is between the disastrous radicalism of budget cuts and a constructive radicalism of full employment. Or between a disastrous radicalism of bank bailouts and a constructive radicalism of social development. Europe must choose.

As a very young man, I was drafted in 1975 to the Banking Committee of the US House of Representatives and I took part in a financial rescue programme for the City of New York, then in financial and economic crisis. It included, among many radical provisions, a requirement that the city’s debt be restructured and that bondholders take a loss. Shortly, a call came from the former governor of New York, Averell Harriman – at one time Roosevelt’s ambassador to Stalin – requesting a briefing. I was dispatched. I found Harriman – octogenarian and recovering from a hip fracture – in his pyjamas, seated on a couch in an inner room of his Georgetown mansion. On the wall to his right were Van Gogh’s sunflowers. In a glass case to his left was a Degas ballerina. In this setting, I attempted to explain why the people’s representatives were demanding sacrifice mainly from the rich. Presently he nodded, leaned forward on his cane, and intoned in a deep voice: “I understand completely. Capital must pay, as well as labour.”

James K Galbraith

Original text in English

James K Galbraith holds the Lloyd M Bentsen, Jr, chair in government/business relations at the LBJ School of Public Affairs, University of Texas at Austin, and is the author of The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too, Simon & Schuster, 2009